Managerial Economics

Introduction, Basic Principles and Methodology

The central themes of Managerial Economics:

1. Identify problems and opportunities

2. Analyzing alternatives from which choices can be made

3. Making choices that are best from the standpoint of the firm or organization

• Not true that all managers must be managerial economists

• But managers who understand the economic dimensions of business problems and apply economic analysis to specific problems often choose more wisely than those who do not.

Some Economic Principles of Managers

1.Role of manager is to make decisions. Firms come in all sizes but no firm has unlimited resources so managers must decide how resources are employed

2. Decisions are always among alternatives.

3. Decision alternatives always have costs and benefits

Opportunity cost = next best alternative foregone.

Marginal or incremental approach

4. Anticipated objective of management is to increase the firm’s value

• Maximize shareholder’s wealth

• Negative impact = principal-agent problem

5. Firm’s value is measured by its expected profits

Time value of money, discount rates

6. The firm must minimize cost for each level of production

7. The firm’s growth depends on rational investment decisions

Capital budgeting decisions

8. Successful firms deal rationally and ethically with laws and regulations

Macroeconomics & Microeconomics

• Economists generally divide their discipline into two main branches:

• Macroeconomics is the study of the aggregate economy.

– National Income Analysis (GDP)

– Unemployment

– Inflation

– Fiscal and Monetary policy

– Trade and Financial relationships among nations

• Microeconomics is the study of individual consumers and producers in specific markets.– Supply and demand

– Pricing of output

– Production processes

– Cost structure

– Distribution of income and output

Microeconomics is the basis of managerial economics

• Methodology, data and application

Methodology- is a branch of philosophy that deals with how knowledge is obtained.

How can you know that you are managing efficiently and effectively?

You need some theory to do some analysis.

Without theory, there can be no good analysis

Microeconomics (probably more than other disciplines) provides the methodology for managerial economics

Managerial Economics is about both methodology and data

You need data to plug into some model to do some analysis.

This gives you the information to manage

Managerial Economics lends empirical content to the study of effective management

Review of Economic Terms

• Resources are factors of production or inputs.

– Examples:

• Land

• Labor

• Capital

• Entrepreneurship

• Managerial Economics

– The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.

• Managerial economics is the use of economic analysis to make business decisions involving the best use (allocation) of an organization’s scarce resources.

• Relationship to other business disciplines

– Marketing: Demand, Price Elasticity

– Finance: Capital Budgeting, Break-Even Analysis, Opportunity Cost, Economic Value Added

– Management Science: Linear Programming, Regression Analysis, Forecasting

– Strategy: Types of Competition, Structure-Conduct-Performance Analysis

– Managerial Accounting: Relevant Cost, Break-Even Analysis, Incremental Cost Analysis, Opportunity Cost

• Questions that managers must answer:

– What are the economic conditions in a particular market?• Market Structure?• Supply and Demand Conditions?• Technology?• Government Regulations?• International Dimensions?• Future Conditions?• Macroeconomic Factors?

• Questions that managers must answer:

– Should our firm be in this business?

– If so, what price and output levels achieve our goals?

• Questions that managers must answer:

– How can we maintain a competitive advantage over our competitors?• Cost-leader?

• Product Differentiation?

• Market Niche?

• Outsourcing, alliances, mergers,

• acquisitions?

• International Dimensions?

• Questions that managers must answer:

– What are the risks involved?

• Risk is the chance or possibility that actual future outcomes will differ from those expected today.

• Types of risk

– Changes in demand and supply conditions

– Technological changes and the effect of competition

– Changes in interest rates and inflation rates

– Exchange rates for companies engaged in international trade

– Political risk for companies with foreign operations

• Because of scarcity, an allocation decision must be made. The allocation decision is comprised of three separate choices:

– What and how many goods and services should be produced?

– How should these goods and services be produced?

– For whom should these goods and services be produced?

• Economic Decisions for the Firm

– What: The product decision – begin or stop providing goods and/or services.

– How: The hiring, staffing, procurement, and capital budgeting decisions.

– For whom: The market segmentation decision – targeting the customers most likely to purchase.

• Three processes to answer what, how, and for whom

– Market Process: use of supply, demand, and material incentives

– Command Process: use of government or central authority, usually indirect

– Traditional Process: use of customs and traditions

• Profits are a signal to resource holders where resources are most valued by society

• So what factors impact sustainability of industry profitability?

• Porter’s 5-forces framework discusses 5 categories of forces that impacts profitability

1. Entry

2. Power of input sellers

3. Power of buyers

4. Industry rivalry

5. Substitutes and Complements

Entry:

Heightens competition

Reduces margin of existing firms

Ability to sustain profits depends on the barriers to entry: cost, regulations, networking, etc.

Profits are higher where entry is low

Power of input suppliers:

Do input suppliers have power to negotiate favorable input prices?

Less power if

a. inputs are standardized,

b. not highly concentrated

c. alternative inputs available

Profits are high when suppliers power is low

Power of buyers:

High buyer power if

a. buyers can negotiate favorable terms for the good/service

b. Buyer concentration is high

c. Cost of switching to other products is low

d. perfect information leading to less costly buyer search

Industry rivalry:

Rivalry tends to be less intense

a. in concentrated industries

b. high product differentiation

c. high consumer switching cost

Profits are low where industry rivalry is intense

Substitutes and complements:

Profitability is eroded when there are close substitutes

Government policies (restrictions e.g. import restriction on drugs from Canada to US) can affect the availability of substitutes.

Sustainabl

e Industry

Profits

Power of

Input SuppliersSupplier Concentration

Price/Productivity of

Alternative Inputs

Relationship-Specific

Investments

Supplier Switching Costs

Government Restraints

Power of

BuyersBuyer Concentration

Price/Value of Substitute

Products or Services

Relationship-Specific

Investments

Customer Switching Costs

Government Restraints

EntryEntry Costs

Speed of Adjustment

Sunk Costs

Economies of Scale

Network Effects

Reputation

Switching Costs

Government Restraints

Substitutes & Complements

Price/Value of Surrogate Products

or Services

Price/Value of Complementary

Products or Services

Network Effects

Government

Restraints

Industry Rivalry

Switching Costs

Timing of Decisions

Information

Government Restraints

Concentration

Price, Quantity, Quality, or

Service Competition

Degree of Differentiation

The Five Forces Framework

Market Interactions

• Consumer-Producer Rivalry

– Consumers attempt to locate low prices, while producers attempt to charge high prices.

• Consumer-Consumer Rivalry

– Scarcity of goods reduces the negotiating power of consumers as they compete for the right to those goods.

• Producer-Producer Rivalry

– Scarcity of consumers causes producers to compete with one another for the right to service customers.

• The Role of Government

– Disciplines the market process.

Overview of Lectures

Lecture 1: Demand

Lecture 2: Supply

Lecture 4: Quantitative Demand Analysis

Lecture 5: The Theory of Individual Behavior

Lecture 6:Demand Estimation & Forecasting

Lecture 7: Production

Lecture 8: Cost of Production

Lecture 9: Organizing Production

Lecture 10: Perfect Competition

Lecture 11:The Firm’s Decisions in Perfect

Competition

Lecture 12:Monopoly

Lecture 13:Price Discrimination

Lecture 14:Monopolistic Competition

Lecture 15: Oligopoly

Lecture 16: Oligopoly Games

Lecture 17: Labor and Capital Market

Lecture 18: Capital Market

Lecture 19: Economic Equations and Their

Solutions

Lecture 20: Economics Applications of

Derivatives

Lecture 21: ECONOMIC APPLICATION OF

DERIVATIVES – A

Lecture 22: ECONOMIC APPLICATION OF

DERIVATIVES - A

Lecture 23: ECONOMIC APPLICATION OF

MAXIMA AND MINIMA-A

Lecture24: MAXIMIZATION OR

MINIMIZATION (OTIMIZATION) OF

MULTI-VARIABLE FUNCTIONS OR TWO

OR MORE VARIABLE

Lecture 25: CONSTRAINED OPTIMIZATION

Lecture 26: CONSTRAINT OPTIMIZATION –

A

Lecture 27: Correlation & Regression

Lecture 28: Measuring a Nation’s Income

Lecture 29: Money

Lecture 30: Monetary Policy

Lecture 31: Fiscal Policy and NI Determination